The Outlook for Inflation

The US inflation rate has been extremely low since 2009, averaging only 1.6% per year. That’s below the Federal Reserve’s target of 2%. But recently Fed Chair Janet Yellen warned of a phenomenon called “pent-up wage deflation”, which is a complicated way of saying that inflationary pressure could suddenly surge as the economy picks up steam. So how much risk is there of a spike in inflation?

Despite Yellen’s warning, the answer is that a substantial increase in the inflation rate is still very unlikely. Part of the reason is that many of the factors that have kept inflation so low recently are still applicable: with the unemployment rate at 6.1% (and even more people “underemployed”) there remains some slack in the economy, and an aging population should continue to put downward pressure on the inflation rate.

But even if inflationary pressure builds up, it probably won’t lead to a runaway inflation rate. Inflation has been so low for the past 30 years largely because of the actions of the Federal Reserve: after the inflationary surge of the late 1970’s they realized that they could very effectively keep inflation contained by raising interest rates (or simply by credibly promising to do so). The Fed should therefore easily be able to raise interest rates to prevent inflation from significantly exceeding its 2% target.

That doesn’t mean there would be no effect on your investment portfolio. Investments such as bonds (particularly longer-term bonds) that are hurt by higher interest rates would suffer in such a scenario. But the effect of the inflationary pressure would manifest itself in higher interest rates, not in higher prices for the goods and services you buy on an everyday basis. Even if the economy strengthens, an inflation rate near the Fed’s 2% target is still the most likely outcome.